The rule of thumb when it comes to initial public offerings, or IPOs, is avoid them. By participating in an IPO, an investor is necessarily paying a premium (remember, IPOs are meant to help a company raise as much money as possible) for an unproven company and/or management team. Obviously, that's a risky combination.
And while a handful of IPOs -- think Google
Hurts so good
But I'll admit: Even if I know I shouldn't invest in them, I'm at least always curious about the new companies coming public. Some are fascinating to watch -- think back to Vonage
Those, in other words, are the three frameworks most investors should use to analyze IPOs (and I guarantee every IPO will fit into one of these three categories):
- Total train wrecks.
- Fascinating, but speculative.
- Slightly too expensive.
While the first two groups generally aren't worth your time or hard-earned investment dollars, the IPOs that fall into that third category are worth adding to your watch list, in case the companies stumble and their stock prices drop. Rosetta Stone and OpenTable, for example, are two names I continue to watch today.
Another name for your watch list
Also making a run for inclusion on my watch list is newly public Country Style Cooking Restaurant Chain
If you've followed our research at Motley Fool Global Gains, then you know one of the long-term themes we're betting on is the rise of the Chinese consumer. The reason for this is that China is at a crucial turning point in its economic development. While it's produced better than 10% annual GDP growth for the past three decades on the strength of its export manufacturing sector, things have to change if China is to continue its growth trajectory. That means closing the gap between the haves and the have-nots and fostering greater domestic purchasing power -- purchasing power that will benefit consumer-oriented companies such as Country Style Cooking.
Further, with a concept that's already proved popular in at least one market, profit margins that check in near the top of the industry, and significant growth potential, Country Style Cooking appears to be the type of company that can take advantage of that tailwind. Of course, IPO investors paid up for that potential. My valuation model for the company indicated that the $16.50 offering price was baking in better-than-30% annual sales growth over the next decade, making Country Style Cooking a $1.6 billion (by revenue) business by 2020. For a company with just $70 million of sales in 2009, such growth will require significant execution from a management team that has no experience running a company on that scale.
Bu what do I know? Investors bid Country Style Cooking's shares up more than 50% -- to $25 -- on Tuesday, its first day of trading. You can extrapolate the magnitude of expectations now baked in to the company's stock price.
An opportunity missed?
While it's easy to think that Country Style Cooking will never come back to earth, remember that this is an unproven company operating in a volatile economy that investors, at least at this point, are quite skeptical of. Not only are China bears worried about China's housing bubble and slower growth in its economy, but Chinese companies also don't have the best reputation for corporate governance. Should Country Style Cooking stumble in its first few months as a public company, expect its stock price to drop just as rapidly -- or even more so -- as it has appreciated.
Will this change the underlying value of the company? Not necessarily, which is why I'm adding Country Style Cooking to my own watch list as another potential play on the rise of the Chinese consumer. I'm looking for a much lower price, or for management to demonstrate that it deserves the confidence IPO investors have placed in the company. Remember, though: Even if the company isn't a total train wreck or uncomfortably speculative (and Country Style Cooking doesn't appear to be either), the odds are on your side if you expect the stock price to eventually come down.Tim Hanson is co-advisor of Motley Fool Global Gains. He does not own shares of any company mentioned. Google is a Motley Fool Inside Value recommendation. Google and OpenTable are Motley Fool Rule Breakers selections. Rosetta Stone is a Motley Fool Stock Advisor pick. Rosetta is a former Motley Fool Options choice. The Fool owns shares of Google. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.
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